Global warming has increasingly become an issue for mankind, and over the past years, new regulations and social trends have developed with the aim of bringing pollution down and neutralizing global carbon emissions. Compliance carbon markets, in which carbon allowances are traded and regulated by mandatory national or intra-national regimes, are expanding rapidly. Carbon allowance as a new asset class is on the rise.
Total turnover of global carbon markets in 2021 amounted to 15.8 billion tonnes – equivalent to 15.8 gigatonnes of carbon dioxide (CO2) – which was 24% higher than in 2020. Total value of the turnover in 2021 was €760 billion (US$823.27 billion), compared with €288 billion in 2020. The majority of the increase was due to price movements – prices for carbon allowances worldwide have been rising quickly. This has especially been the case for the European Union Allowances (EUAs), which rose some 144% in value in 2021.
A similar trend can also be seen in the North America, UK and New Zealand carbon markets. Last year also witnessed the start of the China nationwide emissions trading system (ETS), the largest in the world in terms of the amount of carbon covered. It initially covered around 4 billion tonnes of CO2 or 30% of its national greenhouse gases (GHGs).
EU ETS global dominance
At the epicentre of the global carbon market is the European Union Emission Trading System (EU ETS). The EU ETS in 2021 traded 12.2 billion EUAs with a total value of €683 billion, accounting for 90% of all the global carbon trading value. The EUA is an entitlement to emit one metric tonne of CO2 or an equivalent amount of GHGs under the EU ETS.
With higher EUA prices and a growing number of market participants, the EU ETS leads the global fight against climate change. Established in 2005, it is the world’s first, largest, most mature and globally recognized carbon ETS.
The two key drivers of the unprecedented price increase of the EUAs last year were expectations of tighter policy to regulate the market balance of them and the extremely high natural gas prices. The EU ETS also saw an influx of traders, most notably, from investment funds that were attracted by their proven profitable investment opportunity over the last three years.
The rising importance of carbon allowance worldwide, and the sheer scale and significance of the role the EU ETS plays in the quest for carbon neutrality, should be closely read into the market by investors.
Assessing EU carbon market instruments as asset class
In terms of accessibility, most regional ETS allowances are already available under so-called cap-and-trade schemes on public exchanges. Investors can participate in an auction or by buying physical certificates or futures contracts in secondary markets. EUA futures contracts, representing lots of 1,000 carbon emission allowances, are deliverable to or from the Union Registry under the EU ETS and are the most liquid of EUA instruments. The trading volume of EUA futures contracts on Intercontinental Exchange (ICE) accounted for more than 90% of the volume among all exchange-traded EUA futures contracts, which in turn accounted for more than 90% of all EUAs traded.
Rather than investing directly in spot and futures EUAs, there have been products developed around it as well, most notably exchange-traded funds (ETFs) and structured notes with payoff linked to EUA or EUA futures and with consistent valuation methodologies. There are five criteria to appraise an investment product: accessibility, size, liquidity, standardization and transparency. An ETF, being a regulated investment product itself, and a public exchange-traded one, offers convenience and transparency to both institutional and retail investors. Carbon futures ETFs tracking the ICE EUA Carbon Futures Index are one such example.
Capitalizing on robust, liquid carbon futures markets
There are obvious reasons for companies, or compliance entities, to use EUA or EUA futures. First and foremost, EUAs are used by compliance entities to offset their emissions in the regulatory scheme. Second, carbon futures can meet the hedging needs of companies that have an obligation to comply with carbon emission rules. The basic objective of the futures market is to help participants manage the risk of price volatility. And third, carbon futures can help companies manage liquidity. Instead of participating in auctions or spot buying, companies just need to pay the margin to obtain the quota.
For investors, there are also compelling reasons why they should support the development of robust and liquid carbon futures markets. A deep market allows people to value the asset and profit from it, and that, in turn, will deepen the market. In addition, the price signals produced in the market help policymakers, regulators and corporates with their efforts in green transformation. The EUA has certainly proven its credibility and robustness during its 17 years of existence.
While directly trading EUA futures and options on exchanges or over-the-counter with banks is straightforward for professional investors like fund houses, the development of carbon futures indexes and carbon futures ETFs facilitates both institutional and retail investors to take part in the market. Currently, there are a few existing ETFs tracking the ICE EUA Carbon Futures Index in the market, with the Stock Exchange of Hong Kong hosting one, the first of its kind in Greater China available for investors in the Asia-Pacific time zone.
These ETFs invest in the most liquid and representative ICE EUA futures contracts by tracking the ICE EUA Carbon Futures Index (Excess Return), which measures the performance of a long-only basket of EUA contracts. As the carbon market exhibits low correlation with other assets, it is an excellent choice to deliver portfolio diversification while being a straightforward instrument for all investors to participate in the green transformation.
In recent years, the EU has put into place aggressive mechanisms to tighten the supply of EUAs and promote the effectiveness of the EU ETS as a major tool to fight climate change. These tools include the Paris agreement, a global framework with a long-term goal that aims to avoid dangerous climate change by limiting global warming to well below two degrees Celsius and achieve climate neutrality by 2050. Fit for 55, a short-term plan of the EU, aims to reduce GHG emissions by 55% by 2030 from 1990s level. That represents a much more aggressive goal than the EU's previous pledge to reduce GHG missions by 40% by 2030.
The EU ETS, the cornerstone of the EU’s climate policy efforts, has contributed significantly to the reduction of GHG emissions, as exemplified by the 2020 emission level, which was 31% lower than the 1990 level and surpassed the original plan of a 20% reduction. The EUA price not only is the barometer for carbon allowance as a rising asset class, but it also has become one of the most important indicators on the global pathway to net zero.
No other investment has the dual benefits of contributing to the price discovery of externality and, hence, tackling arguably the most important issue for our time, while also providing investors with diversification benefits and upside potentials. One of the best ways for investors to participate in global carbon pricing – during Asia-Pacific hours – is probably an ETF in Hong Kong, one of the most recent examples of financial innovation.
Ning Lin is the managing director of China International Capital Corporation Hong Kong Asset Management.